SEBI underlines pivotal role of Clearing Members in risk-management architecture

SEBI underlines pivotal role of Clearing Members in risk-management architecture

Clearing Agents act as intermediaries between the client/trading member and the clearing corporation and prevent the risk of default in settlement by adopting various risk management/containment measures such as margin collection, etc.

SEBI on 29 January 2021 imposed a penalty of Rs 1 lakh on each of the Noticee 1, 2 and 3 - Investmart Comodities Ltd, Neer Ocean Multitrade Pvt. Ltd and Mid-India Comodities Pvt Ltd respectively.

Present proceedings emanated from a show cause notice (SCN) issued by Securities and Exchange Board of India (SEBI) under Section 15-I(3) of Securities and Exchange Board of India Act, 1992 (SEBI Act, 1992) to the Noticees calling upon them to show cause as to why penalty which shall not be less than 1 lakh rupees but which may extend to 1 crore rupees in terms of Section 15HB of the SEBI Act, 1992, should not be imposed on the Noticees.

The Adjudicating Officer (AO) opined that regarding the amendments made to penalty provisions, as amended by Securities Laws (Amendment) Act, 2014, the Statement of Objects and Reasons of Securities Laws (Amendment) Bill, 2014 provides that amendments to these provisions have been made to provide that while imposing monetary penalties, the adjudicating officers have discretion to impose minimum penalties, which shall not be less than 1 lakh rupees, for contravention of the provisions of the said Act.

Thus, legislative intention behind the amendments made to the penalty provisions in the year 2014 is also to introduce minimum penalties and no other interpretation of these penalty provisions is called for.

The show cause notice alleged that the Noticees had violated Clause A(1) and Clause A(2) of the Code of Conduct for Stock Brokers. In the AO Order, the Noticees had been found guilty of violating only Clause A(2) and violation of Clause A(1) was not found by the adjudicating officer.

The Noticees were the Clearing Member of NCDEX. The Clearing Members of a stock exchange play a pivotal role in the risk management architecture under the settlement guarantee framework under aegis of clearing corporation of the anonymous trading platform offered by a stock exchange.

They act as intermediaries between the client/trading member and the clearing corporation and prevent the risk of default in settlement by adopting various risk management/containment measures such as margin collection, etc.

In the event of the default by a client/trading member, the clearing member is expected to ensure that the settlement is seamless, without the default turning into an event of systemic risk. Thus, even if there is a default by the client, the clearing member, at the first instance, is expected to absorb the loss i.e. make good the default and ensure that the settlement is not disrupted.

Similarly, every call for MTM obligations made by the stock exchange, is expected to be met by the clearing member on time, regardless of any delay/default by the client/trading member. It was noted that meeting the MTM pay-in obligations on time in the derivatives market is as critical as meeting the pay-in obligations on the final settlement day.

Every delay in meeting the MTM obligations by the clearing member, aggravates the potential risk of default at the time of settlement of the underlying derivative contract. As matter of prudent business practice and for maintaining integrity of market, there ought not to have been a second or subsequent bank run event.

A second bank run is initiated by the clearing corporation only when there are insufficient funds in the first bank run. In the instant case, according to the Noticees own admission, there were delays on three occasions, seven occasions and 16 occasions in the first bank run in payment of MTM obligations by Noticee No. 1, 2 and 3, respectively.

It was observed that such delay on multiple occasions was a matter of concern and reflected poorly on the intermediary for failure to exercise due diligence which was part of risk management measure to prevent default in settlement.

Also, on certain occasions, the Noticees were unable to deposit the MTM obligations even on the end of T+1 day. This was a matter of even greater concern. Each of the Noticees herein, had argued that the Noticees cannot be said to have defaulted in their MTM obligations, since the shortfall was ultimately met from their Additional Base Capital as maintained by each one of them with NCDEX. No merit was found in such an argument.

The Additional Base Capital was meant to serve as cushion/collateral for providing exposure to all the clients of the Noticees. It was only when the Noticees failed to meet the MTM obligations on time, NCDEX was forced to draw funds from Additional Base Capital, which indirectly effected the ability of other clients of the Noticees to take exposure.

Having Additional Base Capital, could never have substituted the requirement of meeting the MTM obligations. Had the Noticees been diligent in the conduct of their business as a clearing member, the requirement for using the Additional Base Capital ought not to have arisen in the first place. Hence, the AO found that the Noticees were guilty of violating Clause A(2) of the Code of Conduct as contained in Schedule II read with regulation 9 of the SEBI (Stock Brokers) Regulations, 1992.